What’s an Index Fund?
Let's dive into index funds. These are a passive investment, meaning a team reviews them often, but not constantly like mutual funds. As a result, they’re much lower risk than picking individual stocks, and have much lower fees than mutual funds. They’re popular thanks to their simplicity and effectiveness.
So, what is an index fund?
An index fund is a type of mutual fund that aims to replicate the performance of a specific market index. There are many market indexes, and they’re essentially just groups of stocks and/or bonds that have something in common. For example, there’s an index that contains all of the biggest technology companies in Canada, and one that includes all of the clean energy companies in Canada. There’s also a popular index that you might’ve heard of that contains the largest 500 companies in the US (called the S&P 500). An index fund aims to match the performance of the index it’s following. So an index fund for the S&P 500 index will try to match the growth of the companies that are in the S&P 500 index. Rather than actively selecting investments, index funds seek to match the performance of the index they track.
Pros and Cons of Index Funds
Pros:
Low Costs: Index funds typically have fees (called a management expense ratio or MER) compared to actively managed mutual funds, making them a cost-effective investment option.
Diversification: By tracking a broad market index, index funds provide instant diversification across multiple stocks or bonds, which lowers your risk (it’s never a good idea to put all of your eggs in one basket with investing).
Passive Management: Index funds require minimal oversight, as they aim to replicate the performance of an index rather than beat the market.
Cons:
Limited Upside Potential: Since index funds aim to match the performance of an index, they’re not going to get you that “get quick rich” outcome of investing that you might see on the news or Reddit. These are steady, long-term investments that ideally you just keep adding more money to over time, and they grow at a moderate pace so you can cash out your profits when you retire.
Lack of Customization: Index funds are designed to track specific indices, offering limited flexibility for investors who want to tailor their portfolios to specific preferences or goals. If you want to become the type of investor who is hand-picking stocks and constantly watching the news to figure out if you should buy or sell, an index fund likely isn’t right for you. But, if you’re like us and prefer to be pretty much hands-off with investing without paying high fees, an index fund might be right for you!
Not all index funds are equal! There are some index funds that follow a riskier index (like an index that only includes tech stocks), while others follow more broad and diverse indexes. And while index funds tend to have lower fees than mutual funds, there are some sneaky index funds with high fees! So make sure you do your research before picking one!
Investment Minimums: Some index funds require a minimum amount to be invested at a time (e.g., must deposit at least $1,000 in the index fund). ETFs on the other hand tend to have no minimum amount, so if you don’t have a large amount of money to invest index funds may not be the best option.
KEY TAKEAWAYS:
Index funds offer low costs, broad diversification, and passive management, making them suitable for long-term investors seeking a hands-off approach.
Consider your investment objectives and risk tolerance when choosing between index funds, mutual funds, and ETFs.
Index Funds used to be very popular in the US as a low-cost alternative to ETFs. While they’re still popular today, ETFs continue to grow in popularity and are our favourite option for hands-off, low-risk investing. Head over to our blog on ETFs to learn why.
About The Authors
Amanda and Siobhan found a shared passion for personal finance shortly after completing their MBAs in 2018. Amanda excelled as a Director of Product in the tech industry, while Siobhan established herself as a leader in e-commerce before transitioning to academia as a Professor.
In 2020, they joined forces to found Hiver Academy, a platform born from their own experiences and triumphs in conquering student loans and building wealth. Realizing that financial success is within reach once the complexities are simplified, their mission now revolves around empowering individuals to achieve financial freedom.
With a wealth of knowledge and a commitment to demystifying money and investing, Amanda and Siobhan are dedicated to helping others navigate the path to success.
